The yield curve is a simple representation of several yields or interest rates across different maturity dates for a similar debt contract. The curve shows the relationship between the interest rate that a bond pays and when that bond matures for a given borrower in a given currency. The most frequently reported yield curve compares the 3-month, 2-year, 5-year and 30-year U.S. Treasury debt. This yield curve is used as a benchmark for mortgage rates or bank lending rates.
The shape of the yield curve denotes the cumulative priorities of all lenders relative to a particular borrower, and is closely scrutinized because it provides an idea of future interest rate change and economic activity. There are three main types of yield curve shapes:
- Normal yield curve: A normal yield curve is one in which yields rise as maturity lengthens, indicating that investors expect the economy to grow in the future, accompanied by rising inflation. The slope of a normal yield curve is positive.
- Inverted yield curve: An inverted yield curve is one in which long-term yields fall below short-term yields. Under unusual circumstances, investors will settle for lower long-term yields now if they think the economy will likely slow or even decline in the future.
- Flat (or humped) yield curve: A flat yield curve is one in which all maturities are very close to each other, while a humped curve is formed when shorter and longer-term maturities have similar yields, and medium-term yields are higher than those of the short-term and long-term.
The most important item in a yield curve is the spread, which is the difference between the interest rates paid on any two bonds in the curve. If a 30-year bond pays 6% while a 5-year bond pays 5%, the yield spread is 1%.The spread is a simple measurement by which to compare bonds, and gives us an indication of the risk premium for investing in one debt instrument over another.